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The Problem with Cap and Trade

After years of delay, the United States is finally trying to tame the emission of gases that lead to global warming. The most likely outcome is some kind of cap- and-trade system that aims to put a lid on these greenhouse-gas emissions and allows firms to trade emission credits.

The European cap-and-trade system, known as the Emission Trading System (ETS), is the world’s largest pollution market, and it offers important lessons for U.S. policymakers (see “Carbon Trading on the Cheap”). One lesson rings louder than all the others: cap-and-trade, by itself, won’t make much of a dent.

Over most of the ETS’s history, prices have been so low that electric utilities have found it cheaper to run their coal-fired power plants than to switch to less polluting natural gas. And prices have been far too low to encourage a big shift away from conventional technologies. Politicians could fix that by tightening the caps on emissions and driving up prices, but even hypergreen Europe hasn’t had the political stomach to do that. Economists love pollution markets for the same reason that politicians are wary: they make real costs transparent. But the ETS is little more than a ­Potemkin market.

The same political logic is now playing out in the United States. When the Obama administration first outlined its budget in February 2009, it assumed that credits might trade at around $14 per ton of greenhouse gas. (That’s the equivalent of little more than a dime per gallon of gasoline–so low that few consumers will notice. The energy markets, on their own, cause much bigger price swings.) The legislation now taking shape in Congress may yield prices whose practical effect will be even smaller. And with the economy still weak, it is hard to see how politicians anywhere will tighten the screws and raise carbon dioxide prices high enough to make a difference.

Behind the façade, cap-and-trade isn’t having much impact because politicians prefer to rely on direct regulation. In Europe, in fact, only about half of emissions are even included in the ETS; dozens of agencies use direct regulation to tame all the rest, including almost all the emissions from transportation and buildings. Even in the power sector, which is part of the ETS, the biggest changes in technology, such as the rapid spread of wind turbines, are unfolding in response to special “feed-in tariffs” and other regulatory policies rather than to the market signal of the ETS.

America’s cap-and-trade system is likely to follow the same path. When Congress completes its political handiwork, the outcome will be a beautiful patchwork of low carbon prices along with a host of stealthy regulatory policies, such as mandates for renewable power and energy efficiency, and subsidies for favored low-emission technologies. Analysts should pay less attention to the elegant (but largely irrelevant) markets and focus more closely on the regulations. Global warming is a serious problem, but the political process is geared to evade the fact that fixing it won’t be cheap.

David G. Victor is a professor at the School of International Relations and Pacific Studies at the University of California, San Diego.